Too Close To Burn

In the response to Shelia Blair’s call for an end to the doctrine of “Too Big to Fail”, I count only one voice, Paul Krugman’s, among the dissent. Even Krugman seems to think that ridding the world of systemically critical institutions is a pipe dream. Suppose, however, that we could get rid of Too Big to Fail, would we want to?

When questioned about the numerous bailouts late last year, Ben Bernanke replied,

If you have a neighbor who smokes in bed and he’s a risk to everybody. And suppose he sets fire to his house. You might say to yourself, ‘I’m not going to call the fire department. Let his house burn down, it’s fine with me.” But then, of course, what if your house is made of wood and it’s right next door to his house. What if the whole town is made of wood? I think we’d all agree that the right thing to do is put out that fire first and then say, ‘What punishment is appropriate? How should we change the fire code? What needs to be done to make sure this doesn’t happen in the future?

Now the Shelia Blair seems to be arguing that to prevent this from ever happening again, no house will be “too close to burn”. All homes will be built so far apart that we can allow one to burn to the ground without endangering the others. Is that a good idea? Aren’t their benefits to density that outweighs the costs?

In the financial world large multinational firms lower the cost of global trade. They allow a manufacturer in China to be connected to his supplier in Malaysia and his retailer in the US through a single financial counterparty. Last summer I met a gentleman from Africa, no older than his mid-20s who had a business harvesting and exporting hardwoods directly to Europe. When I asked him how he managed to set all of this up he said that HSBC did it all for him. They knew the shippers, the customs regulations and the retailers and they could supply letters of credit for the entire supply chain.

Larger firms also lower average costs and distribute research and development expenditures across a wider base. Before it got tangled in the mess from Countrywide and Merrill Lynch, Bank of America was busying itself developing the first fully integrated backend for handling mortgages. It would allow loan officers to pass mortgage applications on for approval utilizing the same system they used to collect the mortgage information. This process would cut down on error, improve the detection of fraud and perhaps most importantly allow Bank of America to handle more of its mortgages in house rather than via brokers. Throughout this crisis broker originated loans has significantly underperformed those originated at the bank itself.

Critics might argue that innovations and cost savings are nice but they hardly compensate for the costs of moral hazard. The problem is that moral hazard is a fundamental part borrowing short and lending long. Restrictions on size or interdependence cannot change the fact that when a financial institution goes down, it is the creditors of that institution who overwhelming bear the costs. For a bank it is the depositors that pay. For an insurance company the policyholders take the loss, and for a shadowy Special Purpose Vehicle, it is the buyers of Asset Backed Commercial Paper. One can’t design a financial firm where the executives or even the shareholders bear most of the costs of failure. Finance is the management of other people’s money and the implicit mitigation of other people’s risk.

This is why regulation is appropriate in finance that would be draconian anywhere else. It is why all institutions that borrow short and lend long must be subject to similar standards. It is also why we shouldn’t be afraid of too big to fail. Systemic has to be handled by a regulatory process that constrains it and an emergency management process that mitigates. It cannot be done, however, by destroying the interdependence that is at the heart of finance itself.

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[…] how interconnected it is with other financial institutions. Targeting size will reduce some of the benefits from scale in banks while leaving smaller but dangerous firms free to go on destabilizing financial […]

[…] how interconnected it is with other financial institutions. Targeting size will reduce some of the benefits from scale in banks while leaving smaller but dangerous firms free to go on destabilizing financial […]